Investing for your kid’s education

Investing in your child's education is the greatest gift
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Investing in your child's education is a lifelong gift.

The high cost of education has Americans carrying almost $1.5 trillion in student debt. You'll be doing your kids a big favor by sparing them the full expense.

The two classic investment and savings accounts for school are the Education Savings Account (ESA), often called the Coverdell ESA after the senator who helped create it, and the 529 plan, named after a section of the IRS code.

With both plans, your money will grow tax free and won't be taxed when withdrawn for eligible expenses.

What is an ESA?

An ESA allows you to invest a maximum of $2,000 per child per year for a range of primary, secondary and post-secondary school expenses. Those include tuition, books, uniforms, transportation and room and board.

You can open an ESA for your child if you and your spouse earn less than $220,000 per year collectively — or you’re single and earn less than $110,000. However, the amount you can contribute dwindles as you earn more. You won't be able to contribute the full $2,000 if you earn more than $190,000 collectively or $95,000 if single. And anything you contribute above the limit can be subject to a 6% penalty tax.

Though you can't put a ton of money into them, ESAs do offer a lot of investing freedom. Funds can be invested in stocks, bonds or mutual funds, and you can switch up the investments whenever you want to maximize earnings.

You can keep investing money after your child turns 18, but the full contributions will trigger a 6% penalty. The account should also be emptied before your kiddo’s 30th birthday to avoid being charged income tax and a 10% penalty tax on the remaining funds.

What is a 529 plan?

The “529 plan” is offered by almost every state and is available to anyone, regardless of income.

You can use a 529 plan to pay for all kinds of college expenses or just tuition for K-12 education. Most states allow the beneficiary to use the funds at any age. If your kid wants to go to college at age 35, that's just fine.

Your investing options are more limited with a 529 plan. You can usually choose between two or three investment portfolios but you won't be able to get more granular than that. And you can only reallocate the funds within your 529 twice a year.

Contributions top out at a much more generous $14,000 per year. However, these plans do have lifetime contribution limits, with some plans allowing up to $300,000.

You can choose a 529 plan from outside your own state, though you might miss out on some tax benefits. Check out what's available through the map below, and be sure to check out our guide to choosing the best one for your kids.

Investing for your kid’s other expenses

Today he's building a block castle - but one day he'll need to buy a house
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Today he's building a block castle - tomorrow, he'll be buying a house

Life will get expensive in your kid's 20s and 30s, with a wedding, a first home and children of their own all on the horizon. Leaving them even a modest nest egg can go a long way.

An investment account opened under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) could be ideal. You'll get to control it until your kid comes of age, and they'll be able to use the money for anything they see fit.

A UGMA will let you gift cash, stocks, bonds and insurance products to your child without needing to open a trust. The gifts are held in the account and managed by you (or another custodian) until the child turns 18.

Meanwhile, UTMA plans can gift all kinds of assets, including real estate, patents, royalties and paintings. The account usually closes when your child turns 21, but some states allow custodians to maintain control until the child turns 25. Not all states offer UTMA plans.

There are no contribution limits for either account — but once you give a gift, you can’t take it back. You might control the asset for a while, but it belongs to the kid, now.

As a result, both of these accounts have tax advantages. In 2020, minors can claim $1,100 of "unearned income" tax-free. The next $1,100 is taxed at the child’s bracket, which is 10% for federal income tax. The rest will be taxed at your bracket.

Keep in mind, having a substantial amount of money in your kid's name may have implications for scholarships and other forms of assistance.

If you're looking for a good UGMA/UTMA account, check out Acorns Early. The service will automatically take the spare change from purchases you make and invest it into an account for your child. You won't even have to think about it until your kid is old enough to receive their windfall.

Keep control for longer

Kids gain possession of the assets when they turn 18 or 21 (or later, if you choose)
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Your child will gain control of their custodial account when they reach the age of majority.

Not sure what your future 21-year-old is going to do with your gifts? Afraid they'll cash out all those investments and buy a motorcycle?

If you want to have more control over when an investment account is handed over to its young recipient, consider opening a money market account in your own name instead.

You can deposit funds and earn solid interest for as long as you want. When the time is right, simply gift the account over to your child.

You won't get the same kind of returns as other options, but your money will be safe from market crashes and youthful shopping sprees.

Get your kids excited about investing

Teach your kid about saving and investing at the same time
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It's easier to inspire your child if you pick a fun company to invest in.

The other way to ensure your financial gifts go to good use is to teach your kids about saving and investing from an early age. This crucial knowledge is another gift in itself.

Try getting them an age-appropriate debit card from Greenlight to teach them about saving. With Greenlight, you can control where your kids are able to spend their money and even set your own parent-paid interest rate. You'll be able to show your kids how their money grows each month when they make good decisions.

To start investing, find an online broker that ideally requires no minimum deposit and doesn’t charge a high fee. The app Stash is great for investing small amounts of money and costs as little as $1 per month.

Kid-friendly companies such as Walt Disney, Build-A-Bear Workshop, World Wrestling Entertainment and Nintendo are all fun investments that will hold kids’ interest. Get them involved in selecting one or two companies and help them keep track of their stocks’ growth.

Once they grasp the basics and get a bit older, you can build your child a portfolio of easy-to-manage index funds or ETFs.

Index funds mimic a market index — such as the S&P 500, which tracks 500 large companies in the United States — and allow you to own a piece of each stock. Index funds have low fees but tend to keep up with their target pretty well. Meanwhile, ETFs are diversified packages of investments that trade just like individual stocks. They also have low management fees.

Getting your kid to save for retirement

It’s never too early to start saving for retirement
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If your teen is bringing in income, you can open a Custodial IRA in his or her name.

You know what they say: It’s never too early to start saving for retirement.

If your teen is bringing in income — maybe they have a part-time job babysitting or delivering pizzas — you can open a Custodial IRA in his or her name. As usual, you can pick either a traditional IRA or Roth IRA, but a Roth IRA will give your kid more freedom with the money. Contributions can be withdrawn tax-free any time.

With a Custodial IRA, you'll manage the account until your child turns 18 or 21 years old, depending on your state, at which point they get control. All growth in the account will be tax-free.

Watching their IRA grow from year to year will teach your kid about the power of saving and the magic of compound interest.

The evidence will be obvious. The real trick is inspiring them to give up their hard-earned pocket money to begin with.

A word of caution

It’s natural to want to help your child get the best financial start in life — but make sure your own finances are on solid ground first.

If you're still working to pay off debt or are struggling to save at least 15% of your pretax income for retirement, focus your efforts on yourself for now. You might consider asking a certified financial planner for help; the ones over at Facet Wealth have plans just for young families.

Finally, don’t feel pressured to set up multiple types of investments for your children. It’s equally generous if you prioritize key expenses, such as education.

Remember, assistance is great, but setting a good example with your decisions will ensure your kids start their investment journey on the right foot.